“Nevertheless, questions lingered as to whether the configuration of asset prices accurately reflected the underlying risks.” – Bank of International Settlement Quarterly Review, September 2016
It’s getting worse – the market’s obsession with the Fed, that is, though some traders who go in for that kind of thing might say it’s getting better. There is a method to the market’s madness, however, one that we would do well to keep in mind as the business cycle staggers to its ending.
For it is ending, as the latest retail sales and industrial production reports made clear last night. The Commerce Department’s measure of retail spending has been showing a twelve-month growth rate below 3% for a full year now, and that is stall speed. In the last two cycles, the annual rate didn’t drop below 3% until the official recession had begun (and was in fact well underway). See The Economic Beat below for more details, but the weakness in industrial production is also long-standing.
Yet the cycle hasn’t completely ended, not so far as the market is concerned, and it won’t until employment gains turn to declines. Fading retail sales haven’t convinced the market, five quarters of profit decline haven’t convinced the market, it’s waiting on job gains and/or “the second half” of the economic expansion (!).
The market’s central-bank obsession is a recurring phenomenon, though this cycle certainly seems to be head-and-shoulders above every other cycle in that respect since the 1980-1982 recession, the last one that the Fed really did cause when it drove short-term rates to nearly 20% and crushed the money supply (to crush double-digit inflation). The method behind the current madness is that we are in a precarious place, lacking the official verdict that the cycle is over (waiting for employment, a lagging indicator, to ring the bell), while lacking any profit reasons for the market’s very rich valuations. The only thing left to do, as is usually the case at the ends of cycles when profit growth has run out, is to watch the Fed for reasons to squeeze out one more trade, one more month, one more quarter.
Yes, there are always the endless drumbeat of Pollyanna forecasts that things are about to get better, mostly coming from mutual-fund land, along with the fingers-crossed, whistle-in-the-dark forecasts of the FOMC staff. Both of these groups do have their reasons. In the mutual fund world, it’s professional suicide to openly predict (or bet on) recessions, so managers just fall back on the excuse that their charter calls for them to be 95% invested and cash allocation is a client decision. Their main concern is not whether or not you gain or lose money, but whether or not they are a few points better or worse than the competition. The Fed, for its part, is institutionally constrained from ever predicting recession and so the forecasts are never negative until we all are aware that recession is here.
The relentless performance tyranny of the calendar (very well illustrated in “The Big Short“) means that money managers are generally afraid to do anything that’s more than a tiny bit out of step with what everyone else is doing. In that world, boldness generally means having a 3.5% allocation to Amazon (AMZN) or Facebook (FB), rather than 3.2%. So at the ends of cycles, we turn our attention away from naughty data about profits and the economy and instead fixate on two things – maybe the central bank will increase accommodation, or maybe the end isn’t until next week/month/quarter. It’s a little bit like being in a castle under siege. There’s no way out and the food may be running low, but people learn to adapt. Maybe the cavalry (the Fed) will arrive, never mind that it won’t be large enough. Maybe someone will smuggle some food in. Until the invaders are inside the walls, though, we carry on with our daily routines.
So the market rallied on bad economic news last week (the Fed won’t raise rates) and sold off on inflation data (maybe it will). It will probably put on a cautious rally going into this week’s meeting, as the market expects no action, and have a little rally afterwards because that’s the market does, unless the chair (in this case, Janet Yellen) says something really disconcerting. She isn’t in the habit of doing that, and the data make it plain that the cycle is nearly over. But the walls aren’t down yet, so what do you think – will the Fed raise rates in September, or December? Is this good inflation, or bad inflation? Are we living in reality, or our own world?
The Economic Beat
The report of a slow-starting week was the August retail sales report. It was a clear miss of the consensus estimate for no change, with a somewhat surprising monthly decline of 0.3% (seasonally adjusted, or SA) overall and a drop of 0.1% excluding autos. The report dropped the Atlanta Fed’s running forecast for current-quarter GDP – which has begun every quarter this year overestimating what retail spending would be – to 3.0%. That’s still ahead of the NY Fed’s 2.8%, which won’t be updated until after the FOMC meeting next week and so has yet to incorporate the disappointing number.
Quite a bit of seasonal adjustment went into headline August retail sales, due to Labor day and the calendar shift of holidays. The seasonal adjustments, they giveth and they taketh away. The year-on-year number for unadjusted sales was much better, showing an increase of 3.05%, but that reflects both weekend shifts (July’s year-year increase was a very low 0.9%) and the moving Labor Day holiday that affects the timing of back-to-school spending. Back-to-school is the second-most important shopping event of the year, after Christmas and ahead of Easter, and the shifting timing of holidays and weekend purchases means that spending at this time of year is perhaps best looked using the third quarter as a whole. Still, year-year weekly comparisons around the first half of September have been disappointingly weak, pointing to another anemic quarter, as July-August combined show an anemic gain.
The other report most important to my own view was August industrial production. It showed a decline of 0.4% seasonally adjusted, also a miss of consensus estimates for a drop of 0.2%. The decline swung the year-on-year decline to 1.1% overall, with a (-0.4%) loss for manufacturing. The August number was slowed by a decline in utility output as record heat subsided, but boosted by the year’s best increase in mining (petroleum extraction, in this case), which may not be sustainable now that the bump in prices has eased.
The New York Fed manufacturing survey showed a second consecutive month of weakness, though not dramatically so, with a headline number of (-1.99), part of the good-bad news on Thursday. The somewhat more influential Philadelphia survey showed a nice gain of 12.8, by contrast, but its internals were weak with declines in new orders, shipments and employment. The surveys are far from precise and provide little to no data about actual activity levels, but the overall tenor was not positive.
For the markets, though, Friday’s release of the consumer price index (CPI) may have been more important. The producer number (PPI) the day before had shown no change, a tad below consensus and leaving various year-year measures at subdued levels. That had helped the inanity of Thursday’s bad-news rally, but the CPI number the next day for a monthly gain of 0.2% was ahead of consensus of 0.1%. If you’re wondering how much this can really matter you’re correct, but it does matter to short-term trading, for whom every bit of news can be a trigger. Perhaps most “ominous” is annual gain in prices, which now stands at only 1.1% overall but – but! – +2.3% on the so-called “core” rate, or excluding food and energy. That’s ahead of the Fed’s 2% target, and while CPI isn’t the Fed’s preferred measure, it did nudge the betting odds on the chances for a rate increase next week. Import-export prices, however, fell in both categories, by 0.2% and 0.8% respectively (SA), pulling the year-year declines to (-2.2%) and (-2.4%).
Next week is all about the Fed meeting, it need hardly be said, and I am firmly in the camp of both those who think the Fed will not move before the election, as well as the one that thinks it’s crazy to bet on policy decisions. Who knows what the FOMC will do, but they will tell us on Wednesday, with chair Janet Yellen throwing in a quarterly press conference afterwards. We also get to see the latest staff forecasts. Whatever the market thinks about what happens next week, the week after has a heavy slate of Fed governors scheduled to speak and do the usual job of saying whatever needs to be said to push back against market volatility.
The main data adds going into the Fed meeting will be from housing – the homebuilder sentiment index Monday, August housing starts Tuesday, existing home sales Thursday. At the end of it all, there probably won’t be any real surprises, though I would keep any eye on existing home sales for any signs of further deceleration.